Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies CENTRAL MOTEK Co.Ltd. (KRX:308170) makes use of debt. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does CENTRAL MOTEKLtd Carry?
The image below, which you can click on for greater detail, shows that CENTRAL MOTEKLtd had debt of ₩81.9b at the end of September 2020, a reduction from ₩89.7b over a year. However, it does have ₩8.69b in cash offsetting this, leading to net debt of about ₩73.2b.
How Strong Is CENTRAL MOTEKLtd's Balance Sheet?
We can see from the most recent balance sheet that CENTRAL MOTEKLtd had liabilities of ₩101.7b falling due within a year, and liabilities of ₩46.9b due beyond that. Offsetting these obligations, it had cash of ₩8.69b as well as receivables valued at ₩48.9b due within 12 months. So it has liabilities totalling ₩91.0b more than its cash and near-term receivables, combined.
CENTRAL MOTEKLtd has a market capitalization of ₩264.8b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
While CENTRAL MOTEKLtd's debt to EBITDA ratio (3.3) suggests that it uses some debt, its interest cover is very weak, at 1.5, suggesting high leverage. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Worse, CENTRAL MOTEKLtd's EBIT was down 55% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if CENTRAL MOTEKLtd can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last two years, CENTRAL MOTEKLtd created free cash flow amounting to 18% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
On the face of it, CENTRAL MOTEKLtd's interest cover left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least its level of total liabilities is not so bad. Overall, it seems to us that CENTRAL MOTEKLtd's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 4 warning signs for CENTRAL MOTEKLtd (1 is significant!) that you should be aware of before investing here.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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